A Liquidity Pool (LP) is a smart contract that contains funds. In the context of a Decentralized Exchange (DEX), it's a pool of tokens locked in a smart contract used to facilitate decentralized trading, lending, and other financial operations. In a liquidity pool, liquidity providers add funds to the pool and receive LP tokens in return.
These LP tokens can be used to claim their share of the pool, or to participate in governance decisions. The main advantage of a liquidity pool is that it doesn't rely on a traditional order book to derive market prices.
Instead, it uses a pricing algorithm which is often based on the ratio between the different assets in the pool. This model has its own benefits and risks. One of the main benefits is the potential for high returns from trading fees, but one of the main risks is impermanent loss, which can occur if the price of the tokens in the pool changes significantly.